The booming Canadian economy hasn't brought any relief to the
struggling Canadian venture system. Now is a great opportunity
for U.S. VCs looking for deals up north.

August 1, 2010--Venture Capital Journal

Canada is the envy of the world. And not just for winning hockey
gold in the 2010 Olympics. While the rest of the globe claws out of
recession, Canada’s economy grew an impressive 6.1% in the first
three months of the year. There were no mortgage meltdowns or bank
bailouts to speak of in the Great White North. Nor was there mass
unemployment—the nation has already regained about three-quarters
of the 400,000 jobs lost during the recession.

Indeed, it’s a great time to be a Canadian. No, strike that.
It’s a great time to be Canadian as long as you’re not the
founder of a tech startup or a venture capitalist.

While the rest of Canada is back on its feet, the venture industry
remains flat on its back, and some fear it may never get up. Deal
activity in 2009 was down 27% from the previous year. And, in the first
quarter of this year, venture firms invested just C$276 million
($265.8M) in Canadian startups, the lowest amount since 1996, according
to the Canadian Venture Capital Association and Thomson
Reuters. What’s more, VC fund-raising has fallen off a
cliff. At the apex in 2001, institutional investors pumped C$2.2
billion ($2.12 billion) into Canadian VC firms, but last year they
wrote checks for just C$380 million ($365.9 million).

There was one piece of good news in mid-July, when Calgary-based Smart
Technologies pulled off the biggest U.S. IPO of the year
($660.11 million). But VCs were left out of that celebration, as
Smart’s largest shareholder was private equity firm Apax
Partners, which bought a sizable minority stake in the digital
whiteboard maker three years ago.

So, is this the end of the line for the Canadian tech scene, which
over the years has produced a number of standout companies, including Research
in Motion, Nortel, Newbridge
Networks, Corel, and Ballard Power
Systems? That may be overstating the case, but there is
certainly a growing sense of concern, both within the country and south
of the border.

“There was a real risk the entire tech ecosystem in
Canada could collapse. That really brought out the Canadian pride in
me. I couldn’t just sit back and watch an entire innovation
engine fall apart.”

Chris Albinson
Managing Director
Panorama Capital

Chris Albinson, a proud Canadian and a managing
director at Panorama Capital in Menlo Park, Calif.,
first noticed something was seriously amiss about a year ago.
That’s when he started getting a flood of calls from Canadian
entrepreneurs saying they couldn’t get funding—not because
they weren’t good companies, but because domestic VC firms had no
money to invest.

At the same time, the once-dominant Nortel had just declared
bankruptcy and was getting sold off in pieces. “There was a real
risk the entire tech ecosystem in Canada could collapse,”
Albinson says. “That really brought out the Canadian pride in me.
I couldn’t just sit back and watch an entire innovation engine
fall apart.”

Albinson’s solution was to team up with other prominent
Canucks to create C100, an organization of well-placed tech execs in
Silicon Valley who want to lend a hand to Canadian startups. It turns
out there are some 300,000 Canadians in the Valley—and every
Nasdaq 100 company has at least two Canadians on its senior executive
team, according to Albinson’s research.

To date, C100 has held a number of networking events and has brought
a total of 70 companies to the San Francisco Bay Area for meet and
greets with various executives and venture investors. Seven of those
companies have gone on to raise $45 million from U.S. venture firms,
Albinson says.

“The mission is simple,” he says. “We need to help
Canadian entrepreneurs wherever they are.”

“The basic problem in Canada is the lack of
high-quality, local money available. We like to syndicate our deals,
and to do that you need a local partner on the ground. That’s
increasingly hard to find in Canada.”

Charley Lax
Managing General Partner
GrandBanks Capital

The Canadian government has also woken up to the extent of the
problem, and is now doing something about it. As a first step, it has
eliminated a prickly tax measure called Section 116, which presented a
huge hurdle to foreign investors looking to invest in Canadian
startups. To avoid Section 116, and the specter of double taxation,
U.S. venture firms had to spend up to $400,000 in legal fees to convert
Canadian companies in their portfolios to Delaware holdings.

“There was tremendous anecdotal evidence that U.S.-based VCs
were not investing in Canada because it was just too much of a
nightmare,” says Stephen Hurwitz, a lawyer with
Choate Hall & Stewart who specializes in
cross-border venture capital transactions. But now that Section 116 has
been effectively repealed, Hurwitz says it is just as easy for American
VCs to invest in Vancouver or Toronto as it is to invest in San
Francisco or Boston.

With or without Section 116, the hurdle rate for investing in
Canadian startups is still much higher than for U.S. startups, says Charley
Lax, managing general partner of GrandBanks Capital
in Wellesley, Mass. Why? “Because the basic problem in Canada is
the lack of high-quality, local money available,” he says.
“We like to syndicate our deals, and to do that you need a local
partner on the ground. That’s increasingly hard to find in
Canada.”

Lax adds that the number of Canadian venture firms he is willing to
co-invest with is small and getting smaller. Indeed, there are only
about 10 active venture firms in the market these days, down from about
100 a decade ago. “Most of the venture firms in Canada
don’t have the oomph to grow these companies from a capital
perspective,” says Lax. “The reality is they are not
staffed with the same kind of people you get here [in the U.S.], people
who are lifelong VC guys or who have built hugely successful
companies.”

Still, that hasn’t prevented GrandBanks from investing in a
half dozen Canadian companies in recent years. Those companies
represent about 20% of the firm’s portfolio. Investments include Colubris
Networks, a wireless infrastructure company that sold to Hewlett
Packard in 2008, xKoto, a virtualization
company that was recently sold to Teradata, and I
Love Rewards, a Web-based provider of employee rewards and
incentive programs.

“Our U.S. co-investors have deeper and broader
relationships than we do. When they are involved, our companies perform
better than if we are in them alone.”

Chris Arsenault
Managing Partner
iNovia Capital

Besides high-quality entrepreneurs and a lack of competition from
other investors, the thing that keeps GrandBanks coming back to Canada
is something called SH&ED (pronounced shred) tax credits.
Basically, the Canadian government will reimburse tech startups up to
65% of their R&D outlays. “This is like cash straight from
the ATM that goes right back into the company’s balance
sheet,” says Lax. “Over the lifetime of the investment,
that ends up being millions of dollars that is non-dilutive and that
can be spent on whatever we want.”

The only catch is that the company’s R&D activity must
remain in Canada, and cannot be conducted across the border, says Lax.
But that doesn’t stop him from moving the management team of
every Canadian startup he backs to the Boston Area. It’s a
strategy he calls Red Sox Nation. “We keep all the engineering in
Canada, but then we hire a new CEO, COO, CMO and CFO here in
Boston,” he says. “The plethora of talent in
Boston—which is home to dozens of billion-dollar tech
companies—is huge, compared to Montreal or Toronto.”

Does this kind of American arrogance bother Canadians? Actually,
Canadian VCs are the first to tell you they welcome their U.S.
counterparts with open arms and wish there were more of them on the
scene. “Our U.S. co-investors have deeper and broader
relationships than we do,” admits Chris Arsenault,
managing partner at iNovia Capital in Montreal.
“When they are involved, our companies perform better than if we
are in them alone.” Most recently, iNovia joined forces with
Panorama Capital and Greycroft Partners to invest in Tynt
Multimedia, a Web analytics startup based in Calgary.

One of the biggest benefits that a U.S. venture firm can offer is
visibility, says Rob Chaplinsky, a native Canadian and managing
director at Bridgescale Partners in Menlo Park. There are many great
Canadian startups that build an early technical lead, but then startups
from California enter the market and get more buzz and attention, he
notes. “It’s sort of analogous to how Stanford professors
can get a term sheet from Kleiner Perkins, while professors from
Carnegie Mellon go unnoticed,” Chaplinsky says. “There is
an unfair advantage to being in the Valley.”

Indeed, Canadian-based tech firms typically secure about 40% less
capital than their U.S. counterparts. “That’s a recipe for
disaster,” says Hurwitz. “Something has to be done fast if
Canada is not to lose a whole generation of entrepreneurship in
technology.”

“Something has to be done fast if Canada is not to lose
a whole generation of entrepreneurship in technology.”

Stephen Hurwitz
Partner, Canada specialist
Choate Hall & Stewart

For Brian Antonen, a partner at Celtic
House Venture Partners in Toronto, that means getting back to
basics and focusing on the nation’s core strength: technology
infrastructure. Celtic House currently has two standout companies in
its portfolio that fit the description: ViXs, a
Toronto-based semiconductor company that makes video processing gear,
and Fresco Microchip, a fast-growing developer of
chips for televisions and consumer electronics. Both of these companies
are rumored to be on track to go public at valuations of $500 million
or higher. If that happens, it will be a huge shot in the arm for the
Canadian venture scene and could bring investors back into the market.

“Our sweet spot is infrastructure, whether it’s chips or
systems or software,” says Antonen. “Web apps, on the other
hand, are not our strength. The concept of starting a Web company in
Canada and competing against the folks in Silicon Valley is kind of
crazy. So don’t expect the next Twitter to come
out of Toronto.”

Still, what U.S. investors would like to see from Canadian
entrepreneurs is more of a Twitter-like attitude—the belief that
they can build big companies with huge valuations and that they can
change the world. Even in his portfolio, Lax notices a big difference
in DNA between his Canadian and U.S. companies. “I do believe we
have several billion-dollar companies in our portfolio, but I
don’t believe any of them are Canadian,” he says.

Until he can say otherwise, Canada will likely remain an
afterthought for most U.S. venture investors.